July 23, 2012
The Honorable Orrin Hatch
SH-104 Hart Senate Office Building
Washington, DC 20510-4402
Subject: State and Local Government Defined Benefit Pension Plans
Dear Senator Hatch:
In the Senate Finance Committee Ranking Member Report issued earlier this year, â&#x20AC;&#x153;State and Local
Government Defined Benefit Pension Plans: The Pension Debt Crisis that Threatens America,â&#x20AC;? you
address the threat these plans pose to the financial stability of state and local governments and to
the retirement security of millions of their workers and retirees. This issue is serious and
controversial, and we commend you for addressing it and for your commitment to solve the
problem.
Virtually all retirement systems have faced difficult challenges during the recent financial crisis and
recession. Critics of defined benefit plans sometimes point to such challenges and suggest the
solution is to eliminate them. In a time of challenging economic and financial trends, this may seem
to some like a reasonable solution, but it comes at a significant cost to participants and taxpayers
and is almost certainly an overreaction.
Pension plans are capable of operating effectively through severe crises. With proper governance
and by pooling and managing risk, these plans can provide participants with a secure and steady
income through extreme economic conditions. Taxpayers can be well-served by these plans, which
deliver this economic security at a reasonable cost when effectively managed.
The Pension Practice Council of the American Academy of Actuaries 1 appreciates meaningful
proposals that develop long-term solutions to pension financing problems and that recognize the
unique characteristics of these plans. To help you craft such a proposal, we offer these comments
with respect to certain aspects of your report.
Essential Goals
In general, we support the four essential goals you identify for public pension reform: affordability
and transparency, generational equity, retirement income security, and state and local funding. But,
these goals can create internal conflicts. Programs should be affordable, for example, but assuring
1

The American Academy of Actuaries is a 17,000-member professional association whose mission is to serve the public and the
U.S. actuarial profession. The Academy assists public policymakers on all levels by providing leadership, objective expertise, and
actuarial advice on risk and financial security issues. The Academy also sets qualification, practice, and professionalism standards for
actuaries in the United States.
1850 M Street NW Suite 300 Washington, DC 20036 Telephone 202 223 8196 Facsimile 202 872 1948 www.actuary.org

retirement security is not inexpensive. Likewise, assuring future taxpayers have no liability for past
years can conflict with goals of affordability or retirement security.
Pension plans should fund all obligations in a transparent, reasonable and rational fashion, seeking
to minimize cost and, ideally, to allocate that cost to taxpayers who benefit from the services of the
workers. But, guaranteeing future taxpayers that they will have no liability can increase current
contributions and might result in future generations paying less than their share of retirement costs.
Maintaining some flexibility regarding this goal tends to reduce aggregate contributions to the
plans.
Suitability of Defined Benefit Plans for State and Local Governments
State and local governments, as well as society as a whole, have an interest in ensuring that retirees
have an adequate lifetime income. This interest is particularly acute in localities in which the
employees of the state or local government are not covered by Social Security. Without a defined
benefit plan, individuals have few effective tools to deal with the challenge of securing lifetime
income for themselves. The efficiency of providing lifetime income through a defined benefit plan
can be significant.
Defined benefit pension plans create value by pooling risk, particularly longevity risk, among a
large number of participants. In addition to the advantages of pooling longevity risk, defined benefit
plans pool investments and manage these investments professionally. The net investment returns of
professionally managed defined benefit plans typically exceed those of individually managed
investments by significant margins. 2
Some pension plans may have taken on more risk than they can sustain or have other governance
issues, but this does not imply that all defined benefit plans are unsuitable for state and local
governments. These plans can be effectively maintained by state and local governments. Improving
the funding and governance of many public plans will not be easy, but the benefits of doing so are
substantial for both plan participants and taxpayers.
80 Percent Funded Ratio
The Ranking Member’s report states that “…80 percent is generally considered the indicator of a
sound government pension plan.” While there is no single, accepted definition of a sound pension
plan, funded status, by itself, is an inadequate measure of the financial strength of any pension plan.
An assessment of the financial health of a pension plan needs to take into account the availability of
resources to support the plan compared with the expected cost of the plan and the risk of variation
in that expected cost.
A funded ratio is a single measure of a plan’s status at one point in time. No single funded ratio
should be used as a measure of a pension plan’s financial health. Funded ratios should be
scrutinized over several years to examine trends and should be viewed in light of the economic
situation at each point in time. Higher funded ratios are expected following periods of strong
economic growth and investment returns such as that experienced at the end of the 1990s. Lower
funded ratios are expected after recessions such as the one begun in 2008 or after years of poor
investment returns. Whether or not a particular shortfall affects the financial health of the plan
depends on many other factors.
2

Other measures of financial health should be examined in addition to funded ratios. These may
include:
 Size of the pension obligation relative to the financial size (as measured by revenue, assets,
or payroll) of the plan sponsor.
 Financial health (as measured by level of debt, cash flow, profit or budget surplus) of the
plan sponsor.
 Funding or contribution policy and whether contributions actually are made according to the
plan’s policy.
 Investment strategy, including the level of investment volatility risk and the possible effect
on contribution levels.
Again, each of these measures should be examined over several years and in light of the economic
environment.
Well-governed plans should have a funding policy in place to meet the full costs of these plans as
well as a history of adhering to this funding policy. Lack of a funding policy or a demonstrated
failure to adhere to a funding policy raises serious concern.
Using 80 percent as an “indicator of a sound government pension plan,” as stated in the report, also
introduces the potential that some will consider 80 percent funding a goal or target, rather than
targeting 100 percent or greater. Such a reduced goal likely would impose an additional cost on
future taxpayers and could subject a plan to severe stress in economically troubled times.
The American Academy of Actuaries’ Pension Committee has just published an Issue Brief
addressing this issue, The 80% Pension Funding Standard Myth.
Exhausted Assets
The Ranking Member’s report also states that “…the pension plans of 11 states are projected to
have exhausted all of their assets by 2020,” and cites a 2009 paper as the source of this projection.
The 2009 source paper uses questionable assumptions and simplistic methods to make this
assertion. For example, the paper assumes that each plan sponsor would contribute only enough to
fund newly accrued benefits, and that none of these funds would be available to pay current
benefits. Ten years later the plans are projected to “run out of money” only because the intervening
10 years’ worth of contributions plus income (well over $1 trillion in aggregate) are simply
assumed to be unavailable to pay benefits. As the GAO noted, “The projected exhaustion dates are
thus not realistic estimates of when the funds might actually run out of money.” 3
To illustrate the problem with these projections, consider the state of Oklahoma, which in the report
was projected to exhaust its assets in 2017. The June 30, 2011 actuarial valuations for the two
largest plans in Oklahoma report assets of approximately $17 billion and benefit payments during
the prior year of approximately $1.5 billion. Contributions for the prior year were approximately
$1.2 billion. If benefit payments continue to exceed contributions by $300 million, these plans have
sufficient assets to last more than 50 years without any investment earnings. Even if benefit
3

payments increase and contributions do not, these plans are not likely to exhaust their assets soon
and certainly not by 2020.
The source paper referenced should not be used as the basis for assessing the potential threat that
state and local government-sponsored pension plans might pose to their sponsors.
Summary
The Academy’s Pension Practice Council supports your goal of having state and local government
pension plans that are affordable, that provide transparent costs, appropriate allocation of costs to
all taxpayers (current and future), retirement income security for employees, and full and complete
funding by the sponsoring entities. The Academy’s professional staff stands ready to help craft
policies to support these goals.
We would be happy to discuss any of these items with you at your convenience. Please contact
Donald Fuerst, the Academy’s Senior Pension Fellow (202-785-7871, fuerst@actuary.org ) if you
have any questions or would like to discuss these items further.
Sincerely,